The term “credit crunch” is very misleading for the current crisis. It suggests that the problem is merely one of confidence, that calm will return if liquidity is introduced to the system.

My view, though, is that the real issue is one of solvency. This is the systemic bankruptcy of 2008.

Mortgages are just the beginning.
At real rates of interest, with real expectations of a reasonable rate of return, many of the deals which have been done since 2003 just do not make economic sense. Thus far, the spotlight has been on one piece of that problem – bad mortgage loans – but I think we’ll see the problem areas expanding rapidly to include a lot of the private equity deals which were done on the basis of free money between 2003-2007. I remember a fatuous statement by some private equity genius that “everybody’s rushing to do the first $100bn deal”. Well, the chickens are coming home to roost. Expect a steady flood of announcements of setbacks, restructurings and bankruptcies as companies that were bought with borrowed money turn out to be unable to service their debt.

Lower interest rates will ease the symptoms only.Dramatic easing of interest rates will help to slow down the pace at which we have to deal with the bankruptcies, but they won’t change the cold reality of the situation, and they run the very real risk of making things worse by encouraging another round of speculation based on free money. We are once again in a situation where the US discount rate is effectively a negative real rate of interest, as a gift to the banks, but staying there for any length of time puts us back into a state of addiction.

Interventions must target bank equity and leverage, not liquidity.The latest move from the UK to buy equity stakes is the best response yet, I think. It dramatically improves the capitalisation of those institutions, it keeps the upside of that move in taxpayers hands (they are taking the pain and funding the bailout, it seems right to preserve the upside for them) and it dilutes the existing shareholders who allowed their institutions to become insolvent. Personally, I’d be inclined to do more than dilute those shareholders.

I don’t see the current $700bn deal making a real difference to US banks. I would expect the US to announce a deal similar to the UK deal soon, but the numbers would have to be larger. Scarily large. Much better for the US to make that move, than to wait for Asian and Middle-eastern sovereign wealth funds to step into the breach.

Depositors in regulated banks should be protected by the governments that run the regulators. Shareholders not so much. Bondholders… maybe.I think the Irish and other countries who have guaranteed the deposits of individual users have done the right thing. Governments setup regulatory authorities, and banks advertise that they are regulated. The people who appoint those regulators need to stand by the approach they take – they should offer a guarantee that they will stand by their product, and when it fails, they will stand by the people who trusted in them. Depositors at banks in the UK really should not have to worry that the bank might fail – such a failure should at most affect the interest rate they receive, not the safety of their capital. Shareholders in those banks, however, should be very worried indeed. There’s an interesting question about bondholders and institutional depositors. By one argument they are sophisticated investors and should be responsible for their bonds. By another argument, they are the very people who can cause massive shifts in funds from bank paper to T-bills, and hence worth keeping pacified. I would lump them in with individual depositors too.

Executive compensation should be structured not fixed.There has been a lot of discussion about limiting executive compensation. That’s just an invitation for armies of consultants and lawyers and accountants to work around whatever compensation limits are put in place. And frankly, I’m hard-pressed to understand how politicians, who constantly vote themselves bigger salaries and expense accounts, are qualified to set bank executive salaries. They effectively WERE in charge of Fannie and Freddie executive compensation, and that wasn’t a stellar success.

What I would say, however, is that financial institution earnings should only be recognised over a seven year period, and bonuses based on those earnings should be held in escrow until that seven year period is up. Imagine if we could now tap into the bonuses of investment bank employees over the past seven years in order to shore up the balance sheets of those banks. That would include the bonuses paid to Mr Fuld, Mr Greenberg, and Mr Greenspan. Anybody care to run the numbers? I think it would be material.

I’m nervous.The big question I’m asking is which sidelines don’t have landmines? My team and I are fortunate to have stepped out of many markets before the current flood of fear. We stepped right into a few problems, but in large part dodged the cannonballs. So far so good. But what does it mean to have cash in the bank, when banks themselves are failing? What does it mean to hold dollars, when the dollar is being debased in a way that would feel familiar to the Reserve Bank of Zimbabwe? These are very dangerous times, and nobody should think otherwise.

This entry was posted
on Thursday, October 9th, 2008 at 10:05 pm and is filed under Uncategorized.
You can follow any responses to this entry through the
RSS 2.0 feed.
Both comments and pings are currently closed.

67 Responses to “It’s a solvency problem, not a liquidity problem”

Mark,
What will come: in a few years time we will have peak oil. Just when the recovery is around the corner we will be hit by the peaking of oil production. That will make this “solvency” problem a walk in the park.

I don’t know what to do, don’t have money to do anything anyway. But you have money so be afraid of losing it and think very hard about how to hedge your self against the Oil crisis.

Dear Mark,
i am the ubuntu user from indonesia, and i love it so much, because its opensource and free.
now, i want to be a linux programmer, but i have only small things knowledge about it.
in this comment, i want your help,to increase my ability to be a programmer.
one day, i want to be a part of ubuntu developer, and spread ubuntu in my place, my country, Indonesia
i just want some help from you, maybe by give me some books for studying about ubuntu and programer
i was 23 years old, my hobbies about computer,mostly ubuntu.but now i’m in accounting college, where i’m borred aboout it, i want to be a programer, and then join with you to develop ubuntu..
please reply my comment to my email address, i’m waiting so much for it,
thanks a lot

The average personal debt of US, UK and European consumers is astronomical: something like 1.42:1 debt vs. asset ratio for Americans, 1.32:1 for British and 1.03:1 for Germans. So people owe a lot more to banks than they own. That is probably why the US economy and world economy doesn’t want to grow much: because people are so heavily in debt. They spend a great portion of their income just repaying debt, meanwhile consumption has far outpaced production. So all the measures to increase consumption won’t really help until balance is restored. The US budget deficit is $500bn per year and its trade deficit is $700bn a year. So the US needs to restore the balance between production and consumption. The rest of the world can’t continue to loan it money indefinitely.

Most women are experienced in nurturing vulnerable dependent legal personae, from helpless, into productive entities, with functional moral consciences.

Why are there, by law or other agreement, not a significant number of women on every major corporate board.
I believe that the domination of board rooms, by alpha males, intent on personal success, underpins and self perpetuates a tendency towards cyclical collapses.

Women are more practiced in making and giving effect to tough decisions in the best interests of dependent third party legal personae.

I have personally been ridiculed by boards, as a “confused and irrational woman” for supporting less profitable, but solid strategic interventions, over and above those that will deliver short term benefits.

Kudos to you Mark for foreseeing that the markets would be atrocious and getting your money out. These are indeed scary times especially for a young entrepreneur like myself trying to find a foothold in this economy. I worry that this economy is going to turn around later than sooner for the reasons that you incurred in your post. There aren’t just one or two problems in the economy but a plethora to solve.